Transitional Success: USSR to EU

Transitional Success: USSR to EU

The Czech Republic

Transitional Success:

USSR to EU

Public finance policy issues during the political

economic transition from centrally planned socialist

economics to free market democratic capitalism.

V550 Dr. Mikesell

November 20, 1996

Rick Ferguson rfergus@indiana.edu

Eric Martin emartin@indiana.edu

Dmitri Maslitchenko dmitri@mailroom.com

Table of Contents

I. Introduction

II. Political Summary: Restructuring for Transition

III. Transition to Market Economy: 1990 - 1991

IV. Problems of Transitional Monetary Policy and the Financial Sector: An

Overview

V. Macro Economic Stability: 1993 - present

VI. Monetary Policy: 1993

VII. Intergovernmental Financial Relations

VIII. Budgetary Overview: 1993 - present

IX. Tax Reform

X. Current Political Economic Considerations: 1996

XI. The EU and NATO

XII. Conclusions

XIII. References

Introduction

In 1989, after nearly 40 years of Soviet control, Czechoslovakia once again

became an independent nation, the Czech and Slovak Federalist Republic.

This transition from Soviet socialism to democracy culminated throughout

Central and Eastern Europe with the literal collapse of the Berlin Wall in

East Germany, the heroic Gdansk Shipyard Strikes in Poland. The student and

worker protests in Prague and Budapest were no less important.

The Czechoslovakian revolution took place peacefully and over a much longer

period of time than events in other former Soviet Union or Warsaw Pact

nations. Hints of major reform in Czechoslovakia began as early as 1968.

Czechoslovakian officials, under Soviet power, moved incrementally to begin

the long road towards decentralization and independent Czechoslovakian

rule. Their increasingly effective efforts became known as the Prague

Spring, a time of growth, change and development.

Success was, of course, neither immediate nor easy to achieve. The Cold War

reached a pinnacle in the Eighties and the winds of change began to blow in

Central and Eastern Europe. The CEE nations endured many hardships. Soviet

oppression, though waning by this time, became largely unbearable. Change

in Czechoslovakia came from the ground up; dissidents quietly began to

return to popular power. The revolution gained momentum by 1989.

‘Revolutionists’ began to demand sweeping economic and political reform.

They were backed by well organized and very timely strikes and protests.

After a two hour general strike on November 27, 1989, proving the immediate

and widespread power and cohesion of the revolution, the Soviet controlled

authorities finally agreed to negotiate.

Through the negotiation process and threat of further massive general

strikes, former dissidents assumed officially sanctioned ‘concessional’

positions. Within months, they gained near complete (and very real) control

of the Federal Assembly. On December 29, 1989, Mr. Havel, a very famous and

popular Czech dissident, became President of Czechoslovakia (renamed the

Czech and Slovak Federalist Republic).

This initial political victory represents only half of the nation’s

success. Within the first three years of self rule, harsh economic (and

subsequent political) realities forced the nation to divide once again. The

nation as a whole was unable to accommodate the vast discrepancies between

the western Czech and eastern Slovak regions. Massive economic reforms

brought this to the popular agenda as Slovakia suffered greatly while their

Czech counterparts seemed to benefit from reform.

The government in Prague wished to move swiftly to further reform efforts.

Slovakia hindered Czech success and in turn suffered greatly by this Czech-

led reform. Slovakia simply could not move as rapidly toward a market

economy due to the economic configuration left to them by years of Soviet

planned economics.

Political Overview: Restructuring for Transition

In 1992, Vladimir Meciar, a very strong nationalist was elected prime

minister of the Slovak Republic, while Vaclav Klaus, a moderate federalist,

was elected in the Czech Republic. Unfortunately, these two leaders were

unable to agree on common economic and political strategies to govern the

CSFR. Klaus’s reform plans, now legendary, were simply inappropriate for

the fledgling Slovak regions. Slovakians felt alienated from the government

reform in Prague. Within a short time it was very clear that the Czech

regions could not completely support their Slovak countrymen through the

transition. The two leaders agreed to divide the Czech and Slovak

Federalist Republic (CSFR) into the Czech and Slovak Republics on January

1, 1993.

Federal assets and liabilities were split between the two nations in a two

to one ratio. The Czech Republic received the larger portions reflecting

both size and population. Again, the split was achieved peacefully, without

massive debate. The two countries agreed to form a customs union. They

implemented identical foreign policies with respect to third countries, and

forbid tariffs or ‘bans’ between themselves. They also formed a temporary

monetary union, which collapsed within months as both countries

unexpectedly experienced a massive drain on foreign reserves during this

time. To more fully understand the current developments in the Czech

Republic, one must examine the historical economic decisions made before

the break-up in 1993 as outlined below.

Transition to Market Economy Overview: 1990-1991

CSFR economic reformers went to work immediately following the collapse of

Soviet rule. The reform package included near complete liberalization of

prices, a complete reversal of former exchange and trade systems and an

impressive preparation for massive and rapid privatization. These efforts

were supported by financial policies including a “pegged” exchange rate,

currency devaluations, and restrictive fiscal, monetary and wage policies.

Monetary Policy

Although monetary policy is discussed in a separate section, it needs to be

briefly addressed here to understand the conditions in which the transition

occurred. Monetary policy in the initial stages of transition ensured that

inflation remained in control throughout currency devaluations and price

liberalizations. The CSFR devalued its currency by 20 percent in 1991 after

several smaller devaluations before hand. Taken as a whole, these

devaluations reduced the value of the currency by half within six months.

Generally, monetary policy remained tight throughout the entire period.

Fiscal Policy

Undoubtably, the goals of the CSFR economic reformers were to drastically

reduce government spending. The former centrally-planned, output-driven

economic policies were no longer effective for the new capitalist

democracy. Restructuring government expenditures was a key component of

reform. The main changes, aside from massive privatization discussed below,

forced reduced subsidies wherever possible. Every sector of society, with

the exception of health, welfare and education, saw an abrupt end to

government subsidies. In 1991 alone, for example, officials reduced

government spending by 12 percent to reach 47 percent of GDP. This trend

continued throughout the transition. Massive government spending, a

hallmark of socialism, ended virtually overnight.

Areas where government spending remained high would remain so throughout

the reform process. Health and welfare for poor, elderly, unemployed and

children is a very difficult situation in any government, especially one in

transition. Reformers focused primarily on industry and energy in the

initial stages, leaving the areas of greater uncertainty to be dealt with

in a more stable political environment.

Price Liberalization

As an almost immediate measure, subsidies to foodstuffs and energy were

reduced by nearly 50 percent. Retail prices for most household items

increased by nearly 25 percent literally overnight. By the end of 1991,

the Czech government controlled only 6 percent of prices in the country as

compared with 85 percent in early 1990. Only basic necessities, oil, and

agricultural products remained under state control. To offset some of these

shocks, wages increased, though only slightly and not nearly enough to meet

the increased cost of living. Politically powerful trade unions prevented

the passage of even more drastic reform measures. Plans in 1991 to increase

the price of electricity, heating oil and coal by nearly 400 percent and

rent by 300 percent were delayed until 1992 and 1993.

Foreign Trade and Investment

After an initial currency devaluation of nearly 50 percent, the government

adopted an adjusted exchange rate connected to a “basket” of convertible

hard currencies. Internal convertibility of hard currencies was established

in 1991. These two measures combined to foster trade and investment.

Initially, the CSFR set a 20 percent surcharge on imports coupled with a 5

percent tariff. These obstacles soon ended as major provisions were passed

to more actively encourage trade and investment. Initial steps toward

private property rights and the dissemination of publicly owned lands

further enhanced the investment environment.

Privatization

Privatization is by far the most critical and complicated development the

CSFR had to address. Speed was critical. The ‘default mechanism’ ensured

that current managers and persons of powers would assume control and create

their own joint venture agreements with foreign entities.

State firms that were nearly completely vertically integrated needed to be

desegregated by form and function. And the process had to be done well, for

flailing industries would simply increase state expenditures. Failures did

not decrease expenditures in compliance with the transitional reform

strategy. The CSFR privatization plan was threefold. Small-scale

privatization was the easiest. Retail stores, restaurants and small service

or industrial workshops were sold to the highest bidders in weekly public

auctions. Where no CSFR buyers were found, a second round of auctions

allowed foreigners to bid.

Property restitution was more difficult. The government needed to equitably

redistribute land that had been taken nearly 40 years earlier. This is a

difficult and involved issue. CSFR citizens are allowed to claim land taken

from them, though the burden of proof is on them. Where no proof exists,

special arrangements can be made for state assistance. In areas of

conflict, the issue will be brought to the courts. A large part of the

country was not in private hands before Soviet rule. Some of this land can

be used as an offering to parties where disputes over ownership exist.

Also, lands that have been improved (shops, developments, houses, etc.) are

sold at specially determined rates to the former property owners. Prices

and possible alternative compensation for those owners who do not wish to

purchase these ‘improvements’ are again settled by a special court

arrangement.

Large-scale privatization progressed swiftly. Some state-owned firms were

sold outright to private interests while others remained under indirect

state control until buyers were found, legal or economic concerns settled,

or parliamentary debate resolved.

Social Policy

The strong tradition of labor unions and their political strength proved

crucial to social security reforms throughout CEE. The CSFR was no

exception. Labor unions were instrumental in keeping CSFR unemployment at

very low levels and social safety net benefits quite high. Essentially the

state guaranteed incomes at a minimal level to meet the ‘cost of living’

for the unemployed or the under-employed. Pensioners and parents of

children received benefits adequately covering bare essentials. Further

benefits for health care were distributed at the local level as the health

system still remained under state control.

Problems of Transitional Monetary Policy and the Financial Sector

Since the introduction of reforms, monetary policy played a key role in the

economic stability of the Czech Republic throughout the transition.

Inflation remained surprisingly low (though relatively high in 1989 and

1990), exchange rates were relatively stable (after initial fluctuations),

and external reserves stayed strong throughout the period (spurred by

unusual and unexpected outside interest in the Czech Republic as the first

reformer to prove its success).

What is perhaps most impressive are the obstacles Czech officials overcame

in developing an effective monetary policy. First, the entire CMEA trading

block was virtually dismantled. Reform and transition would be difficult

even with stable trading partners. In the CMEA, all of the countries were

experimenting with and adjusting prices, exchange rates and policies. It

was very difficult to set monetary conditions correctly, in real or

absolute terms.

Second, within just a few short years, the CSFR itself broke apart for

economic and political reasons. This was largely unexpected and proved

difficult in the policy making arena. As the break-up drew near, officials

had a difficult time determining which policies should be enacted based

upon which of many scenarios might occur in the CSFR.

Third, after finally establishing the terms of the CSFR split and

negotiating a seemingly effective customs and monetary union between the

two new countries, the monetary union failed miserably. Within a few

months, the union caused significant drains on much needed foreign reserves

in both countries and had to be abandoned.

Finally, the Czech tax system had to be completely overhauled.

Additionally, the banking system needed massive reform. Large spreads in

interest rates were common and overall the banks were simply reluctant to

lend on any long term basis, a major impediment to domestic investment and

growth.

All of these massive changes occurred within just a few years. Throughout

these developments, monetary policy remained extremely tight. At the onset

of the reform period, it was at its tightest, with a minor break late in

1991, once the political economic dust had settled. Otherwise, the next

monetary reprieve didn’t occur until the second half of 1993. By 1994,

broad money grew at 30 percent compared with growth of 15 percent a year

earlier. More important than doubling growth figures is that the economy

was able to withstand this growth by 1994!

Interest rates were high throughout the period, and continue to remain high

by most western standards (over 9 percent). Interest rates were not

directly controlled but were subject to central bank reserve requirements

and discount rate announcements. Liquidity was further controlled through

regular auctions of treasury bills.

Bank reform focused primarily on establishing the legal framework for

transactions between the central bank and newly established commercial

banks. Weaknesses still remain in reporting and accounting and the

reluctancy for banks to lend. Several commercial banks have had to come

back under government control to prevent major economic problems.

Macro Economic Stability 1992 - present

By 1992, the CSFR began to show significant signs of success. Though they

were in fact more disadvantaged than many other countries in the CEE, they

fared well. Their export market consisted almost entirely of former members

of the Council for Mutual Economic Assistance (CMEA) who were in the same

transitional position as the CSFR, impeding efficient trade. Fortunately,

inflation on the whole in the CSFR remained remarkably low when compared to

the rest of the CMEA, as did external debt. Inflation did jump just before

the CSFR breakup into the Czech and Slovak Republics. Experts suggest this

occurred in part due to the fear of instability during the breakup and in

part due to an anticipated VAT. As expected, in 1993 (in the Czech

Republic), inflation rose again after introduction of the VAT.

In 1993, free from its less advantaged Slovak counterpart, the Czech

Republic better targeted its economic recovery plan. The plan encompassed

three main elements:

1) A balanced state budget that encompassed sweeping tax reform;

2) A tight monetary policy to reduce the inflation caused by VAT and other

lesser effects (which also improved its external position for trade and

investment); and

3) Moderate wage increases (adjusted to inflation) and a stable exchange

rate.

This reform policy was backed by an IMF “stand by” arrangement as a

precautionary measure. The IMF would assist if the Czech Republic needed

financial assistance. This happened once early in 1993 and Czech officials

repaid the loan before it came due (much to the delight of the IMF).

Unemployment remained remarkably low in the Czech Republic at 3 percent in

1993, while Poland’s figures (another major success story in CEE) still

remain in double digits. Low, virtually non-existent unemployment certainly

contributes to greater political and popular acceptance of the above fiscal

and monetary policies.

Many attribute a major setback in the Polish “Shock Therapy” reform efforts

to the political demands of the labor unions. The Polish President, Lech

Walesa, understood the need to keep wages low to implement the reform. But

he feared for his political power and caved in to labor pressures by

granting wage increases. By doing so he nearly destroyed the entire

economic reform process. He claimed that had he not, the entire political

reform process would have crumbled.

Czech officials didn’t face this obstacle as unemployment throughout the

transition remained low. The political reform process was slightly

segregated from the economic reform process. The small Czech population

(roughly 10 million) was easier to organize than Poland’s 40 million.

Regional differences were less and political factions less pronounced.

Regardless, by 1993, the Czech Republic had a very cohesive popular

political support base which facilitated the economic reforms.

By 1994, foreign trade increased substantially, with much of the growth

occurring between EU member nations. Tourism in Prague, now a “must see” on

any European vacation, contributed to increased trade to maintain a strong

balance of payments and a surplus in the current account. Though FDI by

1994 had decreased (after very high initial investments in 1992 and 1993),

the

capital account maintained high inputs due to the rise in borrowing of

Czech firms (which proved even better for Czech long term economic

success).

GDP began to rise slightly after a period of decline from 1991-1993 of

nearly 20 percent. Privatization entered its second round in 1994 for

enterprises being privatized through voucher programs. The first wave of

privatization is considered a remarkable success (a model to be used

farther east). As this first wave ended in 1993, the Prague stock exchange

began trading and the banking system went though increased and improved

reforms. The Czech Republic was a leader in the CEE in trade and

investment. Economic reform efforts, coupled with the above mentioned

political support, put the Czechs at the forefront of CEE success.

Industry

Industrial output by 1993 declined by nearly 21 percent compared with 1991

figures. This can partially be explained by increases in the service

sector, as investment soared in service sectors and dropped dramatically in

the industrial sector. Also, the industrial sector was the most inefficient

sector in the former centrally planned economy and much of those

inefficiencies were corrected with the introduction of market reform. Most

industries produced less as consumption dropped. And they did so more

efficiently as output based economic plans were no longer used.

It is significant to note that the Czech Republic does not have an

industrial policy. They feel the state does not have enough information or

resources and thus it is most efficient to allow the private sector

complete control. Government could assist with exemptions and subventions,

but the market should determine winners and losers.

However, the Czech government continued, through 1994, to bail out state-

owned enterprises, mostly due to their economic (employment) and political

leverage. In essence, this hurts struggling smaller, private, firms that

are unable to compete with giants, let alone subsidized giants. These large

industrial subsidies are all but gone in most industries today, however

they still exist for politically sensitive or economically vital

industries. In some cases the government reluctantly returned to subsidies

as not all of the initial privatization efforts proved successful. Some

large enterprises were not effectively dismantled and the resulting giant

enterprises were simply too large and inefficient for the new market

economy. It took several years, in some cases, to learn this lesson.

Prices

Consumer price inflation by 1993, after the initial shocks of the VAT,

stabilized at 18 percent. Experts estimate the VAT added 7 percent to

inflation during 1993 and an additional 2 percent can be attributed to

government administered price regulations. Price regulations remained

mostly in the utilities sector. Adjustments from 1994-1995 increased prices

in several key areas including gas, oil, transportation, medicine and

telecommunication tariffs.

Wages

Wage restraints through a “tax based income policy” was an important

feature of the CSFR. Wage restraints ended in 1993, but had to be brought

back by the end of the year by the Czech government. The rational behind

bringing the restraints back was that market forces were not yet adequate

to control wage increases. Wage increases had to remain close to increases

in consumer prices to avoid inflationary difficulties. Therefore, as late

as 1995, up to 100 percent tax rates were applied to wage increases over

allowable limits, effectively keeping wages at desired rates.

Monetary Policy: 1993

By 1993, Czech monetary policy began to stabilize in conjunction with

political and economic indications of success. The basic aims of monetary

policy at this point were simply to maintain internal and external currency

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